Japan; from quagmire to Abenomics to collapse! Part III

Abenomics is the label given to Prime Minster Abe`s three pronged plan to revive the Japanese economy. One of his first acts as Prime Minister was to place trusted inflationist at the helm of BoJ. The new Chairman, Mr. Kuroda, did not disappoint with his plan to double the monetary base in two years. In addition, the BoJ is doing qualitative easing through a pledge to create two per cent annual consumer price inflation in order to manipulate real interest rates into negative territory. They will “do whatever it takes” to reach the target set forth. The Treasury will ramp up spending with a “stimulus” package worth 2 per cent of GDC. Hence, the plan has been dubbed 2-2-2- for doubling monetary base to reach two per cent price inflation together with a fiscal package worth 2 per cent of GDC. A third leg of Mr. Abe`s comprehensive plan include structural reforms, but those are hard to get through the political system and has been watered down.

Source: Bank of Japan (BoJ), own calculations and projections

Source: Bank of Japan (BoJ), own calculations and projections

In short, Abenomics is just a copy of failed policies writ large. We will argue that this time it will trigger something so big that it will break Japan and move them straight into the abyss.

Why? First of all, consider spending. We know that 50 per cent of spending is growing exponentially and will do so for many years to come. The rest of the budget is more or less falling. In theory all other categories could go to zero, but there would still be a deficit. Remember, more than half of revenues are derived from bond issuance. Secondly, if the administration manages to create price inflation, spending will at a minimum follow the price inflation rate forward. Since spending is starting from a much higher base than revenue, the gap is destined to grow further.

More specifically we know spending on interest is increasing even though the BoJ manipulates JGB rates lower. Think about that for a second. Even as interest rates paid falls, total spending on interest rises. Now, assume the price inflation rate goes to two percent annual rate. Holding a 10-year JGB at 80 basis points does not make any sense as the bond holder will lose 120 basis points per year. It is not crazy to assume the 10-year at 3.5 – 4.0 per cent if the BoJ succeed. For a country that has to refinance almost 200 trillion yen per year plus a deficit of 50 trillion, basis points counts. If we add 200 basis points to the average interest paid on outstanding loans, interest payments would soar from 10 trillion to 25 trillion! Interest payment alone would then constitute 27 per cent of total outlays or 70 per cent of tax revenues!

Source: Ministry of Finance (MoF), own calculations

There is no way out of this mess. The best thing would of course be honest default on outstanding debt instead of imposing a burden on the next generation; a generation that had absolutely nothing to do with their parent’s folly. But that will hit the elite in power and will therefore never happen; unless the people overthrow the current rulers in revolution that is.

Conclusions

Japan misallocated large amounts of capital in the 1980s. Instead of dealing with it head-on, they tried to paper over the problems with fiscal expansion, lowering interest rates to laughable levels and expanding the central bank balance sheet. This story should be familiar to all Americans and Europeans by now as the western economies did the exact same thing in the 2000s.

All it did for Japan was to lift public debt to levels that eat away all tax revenue.

In order for them to transition to a system that inflates away the debt for them they will force interest rates to levels that guarantee a run on the sovereign. If they choose to do nothing, they will slowly bleed the country dry of capital to the extent that the people of Japan will see living standards fall for every year.

In addition to the enormous fiscal problems they have created for themselves, they will face the biggest demographic transition since the European population explosion in the 19th century.

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